How does the structure of the VC industry impact investment strategy?

Eighth in a series of weekly posts by myself and Nicholas Lovell of Gamesbrief which answer the fifty questions you should ask before raising venture capital. We expect the series to run for a year after which we will collate the posts into a book. You can find the rationale behind the series here, and the list of questions here. We welcome your comments on any and every aspect of what we are doing.

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My last post in this series covered what an LP looks for in a venture capital fund manager, and the aim of it was to provide the entrepreneurs amongst you with some insight into the pressures on VCs and hence how they behave. This post is similar, although more directly related to the way investors make investment decisions and manage their portfolios, and hence to entrepreneurs.

The vast majority of funds in the venture industry are what we call ‘closed end funds’, which means they operate over a fixed time period. These time periods determine the rhythm by which VC funds operate and are the most important structural element of the venture industry for an entrepreneur to understand.

How closed end funds work

When a VC raises a closed end fund she secures commitments from LPs to fund her investments up to a certain limit (in aggregate the fund size) and over a fixed period of time, known as the investment period. Typically the investment period is five or seven years. It is expected that the VC will fully commit the fund during the investment period, which means that that the investments made plus expected follow-on investments will add up to the the total fund size. It is expected that it will take longer than the five or seven years to exit all the investments and an additional period for realisations is added to the end of the investment period – typically two to three years – giving a total fund life of 7-10 years.

If the VC fails to fully invest the fund during the investment period or fails to fully exit all its investments by the end of the total fund life it can ask investors for an extension. Extensions to the investment period are, in my experience, rare, but extensions to the period for realisations are much more common. Selling startups to a fixed timetable is rarely the way to maximise value and so long as the fund manager is doing a decent job it usually makes sense for the LPs to give them longer to make the exits. The alternatives of attempting to force early exits, replacing the manager or winding up the fund and receiving shares in the underlying portfolio companies are all fraught with difficulties.

The venture fund manager is paid a management fee by the LPs to manage the fund. This is typically 1.5-2.5% during the investment period and then tails off after that. This tapering of fees is designed to encourage VCs to exit their portfolios and return money to LPs.

Impact of closed end funds on investment strategy

The most important effect of the closed end fund structure on investment strategy is to encourage the fund manager to invest quickly. Most obviously, all the money must be committed before the end of the investment period and the manager loses the chance to make new investments. More subtly, good managers know that investments made towards the end of the investment period will be under pressure to exit more quickly than the industry average holding period of around five years and that pressure to exit early can hurt returns. As a result most fund managers look to fully commit their funds in two to three years.

The additional benefit of investing a fund quickly is that it frees the fund manager to raise their next fund, and scale their own business more quickly.

At the next level of detail, funds at the beginning of their investment period are likely to select investments purely on the basis of returns and not pay too much attention to holding period (although they might well try to make a couple of investments that will exit quickly so they look good when they start raising their next fund in circa three years), whilst funds who are towards the end of their holding period will tend to favour later stage companies that are likely to exit more quickly.

Impact of closed end funds on portfolio management

The most important effect of the closed end structure on portfolio management is that as funds come to the end of their life they come under increased pressure to exit their investments. If a company is increasing in value rapidly it is unlikely (but not impossible) that a VC or its investors will want to sell it too early, but for all companies the search for an acquirer will become an increasingly pressing priority as time passes. Most small companies that aren’t growing fast in value have a plan which they hope will get them back onto the skyward trajectory which attracted investment in the first place, and the desire/ability to give these plans a chance is perhaps the biggest casualty of pressure to exit. (It is worth remembering that any business which isn’t growing fast in value will be one of the disappointing ones in a portfolio, which also has an impact on desire to give the business another chance to prove itself.)

Note that, whilst the above is generally true, there are no hard or fast rules here. Extensions can be granted and LPs can and do give VCs more time to exit companies. Forced sellers rarely get top prices.

What this means for entrepreneurs

Hopefully by now you have got the picture – it matters whether you are early or late in a VC’s fund, so make sure you find out before you take investment. It is also worth asking what will happen when they get to the end of their fund life, and whether they think they will have pressure from their funds to exit. I wouldn’t put too much stock in the answers though. As I wrote above, there are no hard and fast rules, and most VCs are optimistic by nature and assume they will be able to persuade their investors to let them exit at the optimum time. Generally speaking, the better returns a fund has the more its LPs will look kindly on requests for more time and for extensions.

There is more to this topic, including what happens when a fund runs out of money and how fundraising schedules interact with investment strategy and portfolio management. I might come back to these later, but this post is long enough already.

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